Depletion Expenses

Definition of Depletion Expenses

Depletion can be defined as decline, fall or reduction in the value of any asset being commonly used in case of natural resources (Oil, gas, iron ore etc.) due to use, consumption, extraction or exploitation of that asset which is written off as expense during an accounting period and reduced from the value of that asset. In this topic, we are going to learn about Depletion Expenses.

Explanation

There is various type of natural resources like oil, natural gas, coal etc. which are drilled out/ extracted out of the mineral-rich land. It is not possible to calculate the total value of resources present beneath the ground until they are extracted completely. GAAP usually makes it a mandatory requirement for companies engaged in mining to capitalise on the acquisition cost of the extracted resources. Depletion expense uses an accrual accounting system to allocate the cost of extracting natural resources. It is a non-cash expense like depreciation and amortization, which reduces the value of an asset incrementally via schedule charges on income. Depletion expenses are charged against revenue generated as a cost of natural resources utilization/ extraction. Charging these expenses as cost helps determine actual profits and identify the company’s actual financial position as on the balance sheet date. When the cost of extraction of natural resources has been capitalized, these expenses are allocated across the leasing period/ utilization period based upon their extraction.

The formula for Depletion Expenses

Derivation: The formula of depletion expenses is somewhat different from the depreciation formula as under the depletion formula, one needs to

1. Calculate the average price per unit.
2. For the purpose of calculating the unit price, one should consider the total cost of natural resource acquisition reduced by the salvage value.
3. The value derived will be divided by a total estimated number of product units.
4. Next, multiply the cost per unit derived in (3) by the total number of units extracted or consumed during a particular period.

The formula is as follows –

Depletion Expenses = ( (cost – Salvage Value) / Estimated Number of Units )* Total Number of Units Extracted During an Accounting Period

How to Calculate Depletion Expenses?

Depletion expenses can be calculated using the following steps –

Step #1

Calculation of Depletion Base / Cost – Depletion base is the cost which needs to be capitalized and is depleted across multiple accounting periods. It is the cost which is incurred to purchase or lease the asset, deployment cost, exploration cost or any other type of cost incurred to restore the asset to its original condition once the depletion of the asset is completed. There are four factors which affect the depletion base –

• Acquisition: It is all associated cost that is incurred to buy or lease land that a company knows is full of resources.
• Exploration: It includes all the expenses that are associated with going inside the land, like digging, mining of the land which was bought or leased.
• Development: It is the cost that is necessary to make the land ready for extraction, like digging wells or tunnels.
• Restoration: These are all expenses that are incurred to make the land back to its original condition.

Step #2

Calculation of Depletion Rate Per Unit – The depletion rate per unit of an asset or any natural resource is dependent on the total number of units which will be extracted. To calculate the rate per unit, one needs to consider the total cost less salvage value then divide it by a total number of estimated units.

Depletion rate = (Depletion Cost  – Salvage Value) / Estimated Number of Units

Step #3

Calculation of Depletion Expense – Finally, the units extracted for a period are multiplied depletion rate per unit in order to calculate the depletion expense for that period.

Depletion Expense = Depletion Rate Per Unit x Total Number of Units Extracted.

Examples of Depletion Expenses

Following are the examples are given below:

Example #1

Coal Inc. has acquired a coal mine on 01 April 2019 for $30,00,000. The acquired mine has an estimated capacity of 20,00,000 tons of coal; the salvage value at the end is zero. There was an additional cost incurred of $60,000 for the development of mine for extracting coal. Coal Inc. extracted 2,50,000 tons of coal from the mine till 31 March 2020. The company wants to know the depletion expenses for the period.

Solution:

Depletion Expenses = { (cost – Salvage Value) / Estimated Number of Units } * Total Number of Units Extracted

The depletion rate is calculated as

Depletion Rate =  (Depletion Cost  – Salvage Value) / Estimated Number of Units

Depletion Cost = $30,00,000 + $60,000 = $30,60,000

Salvage Value = 0

Estimated number of units = 20,00,000 tons

• Depletion Rate = 30,60,000 / 20,00,000
• Depletion Rate = $1.53

Depletion Expense is calculated as

Depletion Expense =  Depletion Rate Per Unit *  Total Number of Units Extracted.

• Depletion Expense for financial year 2019-20 = $1.53 * 2,50,000 tons
• Depletion Expense for financial year 2019-20 = $3,82,500

Example #2

Red Ore Inc. occupied an iron ore site on a 5year lease. Based on the given info, determine yearly depletion cost for all 5 years.

• Cost of acquisition – $11,00,000
• Estimated total extraction units – 1,00,000 Tons
• Salvage Value – $1,00,000

Solution:

Depletion Expenses = { (cost – Salvage Value) / Estimated Number of Units } * Total Number of Units Extracted

• Depletion Rate = {(11,00,000 – 1,00,000)/1,00,000}
• = 10 per unit of iron ore extracted

Therefore, annual depletion charge will be as follows: –

How to Record Depletion Expense Journal Entry

Journal entry for a recording of depletion expense is similar to that of depreciation mentioned as follows: –

If a company does not use Accumulated Depletion A/c –

If a company does use Accumulated Depletion A/c

Under this method, the Balance sheet will depict natural resource at the total historical cost of acquisition reduced by accumulated depletion A/c and net figure in the outer column.

Advantages

Some of the advantages are given below:

• Charging off depletion expense helps management and other stakeholders to determine actual profits earned during an accounting period.
• Charging depletion cost as an expense reduces assets book value from the balance sheet simultaneously. This reduction of book value reflects the actual business financial position as on the balance sheet date.

Disadvantages

Some of the disadvantages are given below:

• The depletion expense method is generally used for periodic reduction in the cost of the asset, and therefore it is possible that the carrying amount of the asset and real market value may differ, thereby failing in depicting actual business worth.
• This method is extremely subjective, especially the estimated value of units to be extracted is difficult to calculate.

Conclusion

Depletion expenses can be described as an expense charged off in books of account against consumption, extraction of any mineral or other natural resource occupied or leased from government or any other person. The concept of depletion is similar to that of depreciation and amortization. This term is commonly used in the case of any natural resource rather than in the case of fixed tangible or intangible asset.

Recommended Articles

This is a guide to Depletion Expenses. Here we also discuss the introduction and how to calculate depletion expenses? Along with examples. You may also have a look at the following articles to learn more –

1. EBITDA vs Net Income
2. Current Assets vs Non-Current Assets
3. Accounts Receivable Factoring
4. Cash Flow from Operations Formula